Electronic copy of this paper is available at: http://ssrn.com/abstract=891620
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THE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLE

Elroy Dimson, Paul Marsh, and Mike Staunton∗

London Business School


Revised 7 April 2006




Abstract: We use a new database of long-run stock, bond, bill, inflation, and currency returns to
estimate the equity risk premium for 17 countries and a world index over a 106-year interval.
Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity
premium for the world index was 4.7% (4.0%). We report the historical equity premium for each
market in local currency and US dollars, and decompose the premium into dividend growth,
multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that
investors expect a premium on the world index of around 3–3½% on a geometric mean basis, or
approximately 4½–5% on an arithmetic basis.




JEL classifications: G12, G15, G23, G31, N20.

Keywords: Equity risk premium; long run returns; survivor bias; financial history; stocks,
bonds, bills, inflation.

∗ London Business School, Regents Park, London NW1 4SA, United Kingdom. Tel: +44 (0)20 7262 5050. Email: edimson@london.edu,
pmarsh@london.edu, and mstaunton@london.edu. We are grateful to Rajnish Mehra and an anonymous referee, participants at over 40
seminars, and the 37 individuals who contributed the datasets described in Appendix 2.

Electronic copy of this paper is available at: http://ssrn.com/abstract=891620

THE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLE
Abstract: We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity
risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government
bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the
historical equity premium for each market in local currency and US dollars, and decompose the premium into
dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that
investors expect a premium on the world index of around 3–3½% on a geometric mean basis, or approximately 4½–
5% on an arithmetic basis.
In their seminal paper on the equity premium puzzle, Mehra and Prescott (1985) showed that the
historical equity premium in the United States—measured as the excess return on stocks relative
to the return on relatively risk-free Treasury bills—was much larger than could be justified as a
risk premium on the basis of standard theory. Using the accepted neoclassical paradigms of
financial economics, combined with estimates of the mean, variance and auto-correlation of
annual consumption growth in the U.S. economy and plausible estimates of the coefficient of
risk aversion and time preference, they argued that stocks should provide at most a 0.35%
annual risk premium over bills. Even by stretching the parameter estimates, they concluded that
the premium should be no more than 1% (Mehra and Prescott (2003)). This contrasted starkly
with their historical mean annual equity premium estimate of 6.2%.
The equity premium puzzle is thus a quantitative puzzle about the magnitude, rather than the
sign, of the risk premium. Ironically, since Mehra and Prescott wrote their paper, this puzzle has
grown yet more quantitatively puzzling. Over the 27 years from the end of the period they
examined to the date of completing this contribution, namely over 1979–2005, the mean annual
U.S. equity premium relative to bills using Mehra-Prescott’s definition and data sources was 8.1%.
Logically, there are two possible resolutions to the puzzle: either the standard models are wrong,
or else the historical premium is misleading and we should expect a lower premium in the future.
Over the last two decades, researchers have tried to resolve the puzzle by generalising and
adapting the Mehra-Prescott (1985) model. Their efforts have focused on alternative
assumptions about preferences, including risk aversion, state separability, leisure, habit
formation and precautionary saving; incomplete markets and uninsurable income shocks;
modified probability distributions to admit rare, disastrous events; market imperfections, such as
borrowing constraints and transactions costs; models of limited participation of consumers in the
stock market, and behavioural explanations. There are several excellent surveys of this work,
including Kocherlakota (1996), Cochrane (1997), Mehra and Prescott (2003), and most recently,
Mehra and Prescott (2006).
While some of these models have the potential to resolve the puzzle, as Cochrane (1997) points
out, the most promising of them involve “deep modifications to the standard models” and “every
quantitatively successful current story…still requires astonishingly high risk aversion”. This
leads us back to the second possible resolution to the puzzle, namely, that the historical premium
may be misleading. Perhaps U.S. equity investors simply enjoyed good fortune and the twentieth
century for them represented the “triumph of the optimists” (Dimson, Marsh, and Staunton
(2002)). As Cochrane (1997) puts it, maybe it was simply “100 years of good luck”—the
opposite of the old joke about Soviet agriculture being the result of “100 years of bad luck.”
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